Careful use of FLPs and FLLCs can help clients reduce estate taxes by creating the potential for valuation discounts. Simply put, if an FLP owns $100 of assets, a 40% limited partnership interest is worth less than $40 because the noncontrolling interest would be tough to sell and LPs by law cannot participate in management.
That means if assets are transferred into an FLP or FLLC and noncontrolling ownership interests are given to heirs - or better yet to well-designed trusts for the client and the heirs - the value of the transfers can be reduced for gift-tax purposes. If the client then dies, the limited partnership interests remaining in the estate may be valued at less then the pro rata share of FLP assets.
What if no planning was done before the client died? There may still be an opportunity to create an FLP to own assets held by different trusts formed under the client's will.
For example, a typical estate plan may set up three trusts on the death of the first spouse: 1) A bypass or credit shelter trust up to the amount of the state estate-tax exemption; 2) A gap trust with the amount equal to the difference between the federal estate tax exemption of $5.12 million and the lower state estate tax exemption; and 3) A marital trust to qualify for the unlimited estate tax marital deduction. While assets in the first two trusts will avoid federal estate taxation in the surviving spouse's estate, the marital trust will be taxed in the survivor's estate. If each of these three trusts contributed assets to an FLP, the FLP interests included in the marital estate might qualify for a valuation discount, reducing estate taxes.
But a word of caution about discounts: Their days may be limited. There have been a host of proposals in Congress to curtail or eliminate discounts. If a client might benefit from the technique, do it now. The most effective way to try to lock in discounts may be to make gifts of noncontrolling FLP interests irrevocable dynasty trusts.
FLP valuation discounts are not necessarily easy or assured. To have a reasonable shot at securing discounts, the partnership must have legitimate nontax purposes. A mere tax play won't fly. The discounts must be supported by a proper appraisal, and many clients may be disinclined to pay for one.
Comprehensive planning must be pursued. For example, in partnership agreements between unrelated parties, it is common to mandate that enough cash be distributed each year to enable each partner to pay the income tax liability attributable to partnership income. But if such a clause is included in a family limited partnership agreement when discounts are sought, it may reduce or jeopardize the discounts.
Most important, the FLP must be operated properly relative to the independent integrity of the entity. The FLP cannot pay personal expenses of the partners. If there are loans to or from the entity, they must be documented, with payment of interest and economic justification disclosed. Unfortunately, a substantial percentage of FLPs are not maintained properly.
BEING IN CONTROL
Every client wants to remain in control. When a client transfers assets into an FLP or FLLC, control over the assets can be exerted through the terms of the FLP partnership agreement or FLLC operating agreement that governs the entity.
For example, a general investment strategy can be specified in the agreement. Restrictions on the transfer of ownership interests or distributions can be detailed. A general partner (or manager of the LLC) can be named to act in a managerial capacity. In addition, a client can designate a successor to serve in these roles in the event of the client's disability or demise. This can all be especially helpful if there is a business or investment purpose that will benefit from unified management.
But if the client retains excessive control, whether under the terms of the agreements or through actual practice and operation of the FLP, the IRS may claim that FLP interests nominally held by others are really included in the client's estate. For example, if the client pays a wealth manager 1% of assets to manage FLP assets, but then withdraws almost all of the remaining profits as a management fee, that control over profits and cash flow may be unreasonable and tantamount to the client having never relinquished any FLP interests. Creditors might make a similar argument.